What is a Fiat Money?

Earlier this month, Utah legislators passed a bill that would make gold and silver coins minted by the government legal tender in the state. Right now, even though the government puts out coins like the gold buffalo, it is considered an asset. It only works at face value — never mind how many ounces of gold or silver are involved. You can’t go into a shop and plunk down a silver eagle coin and have it actually work to buy you some groceries at what you might consider a “fair” exchange considering the prices of precious metals on the commodities market. In Utah, though, that would change. Shops could accept these coins as legal tender, at values accepted by collectors, taking the money beyond face value.

In addition to the idea of allowing gold and silver coins minted in the U.S. (no foreign gold or silver coins are eligible for this treatment) to be used at something more than face value, Utah is forming a commission to study whether or not the state would like to shift to a monetary system based on metals. Utah lawmakers are deeply suspicious of fiat money, which is basically what our entire global economic system is based on.

But what is fiat money?

An Overview of Fiat Money

Fiat is Latin, basically meaning, “let it be done.” Fiat money works because the government says it works, and everyone else agrees. There is no commodity backing it up. You probably remember terms like “gold standard” and “commodity backed currency.” They are being bandied about again in some circles as politicians, economists, investors and others try to figure out what can be done to fix the economy. The idea is that basing money on something solid and tangible will solve our problems.

Fiat money, though, has a long history. The first recorded example was in ancient China. Of course, the paper money issued was originally based on gold, silver and silk. However, as paper bills continued to circulate, rather than being turned in at the end of a set period of time, inflation set in and it became impractical to try backing everything up with a commodity. This practice continued through the Yuan Dynasty until the Ming Dynasty put an end to it in an effort to slow economic expansion.

The American Colonies also issued fiat money. However, during the 1800s, a lot of money was based on silver and gold. A true gold standard wasn’t made U.S. law until 1900. In 1933 gold was outlawed for private ownership beyond jewelry, and in 1946 the Bretton Woods system set up currency exchange between countries based on a system in which gold could be sold to the U.S. for $35/ounce. In 1971, even that was dissolved and now the global economy exchanges currencies based on perception of value. (There are arguments, too, that gold itself is another fiat currency.)

Information as Money: Fiat to the Next Level

Now, of course, our monetary system goes beyond bits of paper said to have value. In fact, with direct deposit, credit and debit cards and PayPal, few us even need to touch paper bills, much less gold or silver coins. Money is largely digital. We all agree that we have a certain amount of “money” in the bank, and if the information is there to “back” you up, you can exchange it for goods or services. In fact, we’re to the point where the entire global economy runs on the idea of money. There isn’t enough paper currency in circulation to “back” the information money in circulation.

So the next question, of course, is: How is it practical to switch back to a gold standard? If there isn’t even enough paper money to back what’s going on, there certainly isn’t enough gold to back it. Right or wrong, we’re in deep with fiat currency. And as long as everyone agrees to keep exchanging services and goods based on bits of information, the system will work. Of course, if people lose faith in the idea of money, it all comes crashing down.

What do you think about fiat money? If you favor some sort of commodity standard, how would you implement it? Could you do so without destroying the economy and reducing everyone to poverty?This post was included in the Best of Money Carnival

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5 Responses to What is a Fiat Money?

Fiat money is doomed to failure in the long run. With nothing to back it’s value it will be valued by the market. As you point out, it is only worth what people agree it is worth. Supply and demand will determine it’s value. History show us that central banks always given in to the the temptation to print more money for short term gains. Because this creates more money chasing the same amount of goods, the price of the goods are bid up, therefore lowering the purchasing power (value) of the currency. Our dollar has been devalued over 90% under the current Federal Reserve. We we ever learn?

Ken – I have to disagree that fiat money is doomed to failure. In fact it’s been a spectacular success. Government creates as much of it as is necessary to juice the economy and give the masses what it wants. The masses are addicted to it and what it brings. It means there’s always plenty of money out there and that at least makes us feel rich even when the economy is flat on it’s back.

As to the devaluation–you’re completely right, but the public have shown that we’ll endure any amount of that as long as it isn’t too extreme. As Joel Osteen said on an (obviously) unrelated matter, “we become functional in our dysfunction”.

Adding to the likelihood of fiat money’s continuance is the fact that hardly anyone is alive today who ever lived in a world where there was a true gold standard (ie, prior to 1933). A gold/silver backed system sounds exotic and dangerous to people today.
If the system were to fail, it would most likely be rebuilt along current lines.

It’ll be interesting to see what plays out in Utah, but my guess is that if the gold/silver as currency plan makes too much headway, the feds will squash it. It would mean a dual monetary system, and as gold and silver rise in value against the dollar, everyone will want to convert dollars to metals. On an international level, that’s what caused the end of Bretton Woods.

actually, I think the ability of fiat money to inflate is one of its great perks, and one of the reasons going back to the gold standard is a horrible idea. From an economic perspective, inflation reduces the burden of debt over time (since as Ken pointed out, a dollar of debt is worth less now than it was 30 years ago). Since debt is basically economic activity from the past that we have to pay for in the present, the quicker it goes away, the happier everyone is-too much debt is bad for individuals and governments, and inflation is a really easy way to get rid of it slowly over time. The only people who should dislike inflation are those who are on non-inflation adjusted fixed incomes (e.g., not social security), banks, and China, since it owns so much US government debt.

Inflation punishes all creditors. That includes all savers, who put their capital into savings accounts, certificates of deposit, money market funds, and bonds of all types. Basically, it punishes the people who have been most responsible in how they handle their personal finances, with the exception of those who invest their personal savings into equities.
However, there is a perverse social value in this. Real wealth is not gold or silver, but the products and services that meet the needs and desires of people. Without the “easy” funds enabled by fiat money, we probably wouldn’t have the huge amount of computing power and associated devices we now have.
Or the advances in biological science and medicine.
Or the developing world where business is growing (though lots of poverty does remain).
We have just gone through a huge bust — and will certainly suffer more of them in the future — but they don’t erase all gains.
And I’d argue that it’s still better to have a nest egg with a value eroding because of inflation, than to have no nest egg at all.
Or just invest primarily in stocks that pay dividends, and reinvest them.

Fiat money is for spending, hard metals are for saving. Financial system backed by Gold Standard infused stability because of its ability to limit inflation http://rationalwiki.org/wiki/Gold_standard_(economics), unlike what we see in the fiat currency system – crazy volatility in prices and markets.

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About the Author

Miranda writes about financial topics for a number of web sites. Her work has appeared on Lifehacker and U.S. News & World Report, and has been linked to from several media sites, including USA Today and the Wall Street Journal.

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